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Monetization, sterilization: What’s going on between the Fed and the Treasury?

Sunday, November 2, 2008

Reader William asked about recent Fed and Treasury actions; specifically, which act is more likely to cause inflation going forward: “would you strictly adhere to thinking the net money creation above treasury issuances is the inflationary tinder? Or is the issuance of government debt inflationary when it is offset by central bank accommodation?”

It is the Fed’s creation of money – through its slew of new credit programs – that will eventually cause an inflationary boom if not taken back (the highlighted portion of your question). The Treasury is sterilizing the Fed’s liquidity measures, rather than the Fed monetizing the Treasury’s debt (just add this to a long list of unprecedented acts by the Fed and the Treasury).

A little economic jargon for some: sterilizing the monetary base and monetizing government debt

First, let’s address sterilizing the monetary base. The Fed’s standard monetary transaction is to maintain the federal funds rate - the interest rate at which U.S. banks make overnight loans to each other - at (or close to, see this post ) the Fed’s chosen target by injecting (the rate falls) and extracting (the rate rises) liquidity from the banking system. Usually the Fed does this through repurchase agreements (repos) or by manipulating the stock of Treasuries on its balance sheet (see Table below).

However, when the Fed wants to keep the federal funds rate unchanged but add liquidity by other means (perhaps by auctioning off funds), the Fed sterilizes the effects of the new liquidity on the monetary base by performing an offsetting open market operation - an overnight repo or selling Treasuries outright.

The counterfactual: The Fed does not sterilize a new TAF auction – let’s say in the amount of $150 billion – and the money supply rises. The Fed allows the new $150 billion to stay in the banking system as excess reserves, which increases the supply of federal funds and reduces the federal funds rate (below the Fed’s target). The money supply increases as banks loan out the new funds, which is inflationary – too much money chasing the same number of goods and services.

Second, Mark Thoma presents a nice example of monetizing government debt - the Fed sterilizes the negative impact on the money supply of the Treasury selling new debt to finance expenditures that exceed its revenue base:



  1. Suppose the government runs a deficit. As an example, let government spending on goods and services be $10,000. For simplicity, all transactions are in cash. Let net taxes from all sources be $9,000 so there is a $1,000 deficit.
  2. The government has $9,000 in cash from taxes, but needs to spend $10,000. Somehow (print money, borrow money, raise taxes, or lower spending) it must get $1,000 more.
  3. Suppose it decides to borrow – issue new debt. Then the Treasury sells a government bond to someone in the private sector for $1,000. The person gives $1,000 in cash to the government and in return gets an IOU (perhaps for, say, $1,100 in one year).
  4. The government now has $9,000 in cash from taxes and $1,000 it has borrowed from the public so it can now purchase $10,000 in goods and services.
  5. Now let’s do the monetization step. This can happen automatically, as explained below, but for now let’s have the Fed conduct a $1,000 open market operation to increase the money supply. To do this, it cranks up the press, loads in some paper and green ink, and prints a brand new $1,000 bill. It takes the $1,000 bill and purchases a bond from the public, for simplicity make it the same bond the Treasury just issued. Then the money supply goes up by $1,000 (and may go up more through multiple deposit expansion) and government debt in the hands of the public goes down by $1,000 since the Fed now holds the bond. The increase in the money supply is inflationary.

So Who’s Monetizing/Sterilizing Who?

The Fed is not monetizing Treasury debt, but the Treasury is sterilizing Fed flows. This new phenomenon is easy to see on the Fed’s balance sheet over the last 2 months.
(Click on Table to enlarge)

The Table lists the Fed’s asset at the end of August, September, and October. In just two months, the size of the Fed’s balance sheet has increased by almost $1 trillion ($936 billion in August to $1,925 billion in October). Further, many of the new liquidity measures – TAF, PDCF (Primary Dealer Credit Facility), Asset-backed Commercial Paper MMMF (ABCP), Net Commercial Paper Funding (CPFF), and Maiden Lane (Bear Stearns financing) - did not exist before 2008 but were created to add liquidity without reducing the federal funds target.

The Fed has loosened its reins on liquidity flows and is pumping the banking system with enough liquidity to fill the Amazon River. The ABCP facility has grow by $120 billion since August when it did not exist, PDCF has growth by $87 billion since August when it was $0, the TAF program has doubled in size to $301 billion with another $750 billion scheduled through March 2009, and the Fed now holds roughly $500 billion in currency swaps that it didn’t hold last year (most of the Other Assets). But this liquidity must be sterilized, and the Fed performs offsetting open market operations, generally selling Treasuries on the open market, for each new measure.

However, by sterilizing its own massive liquidity operations, the Fed’s stock of Treasuries has almost halved since last year, down to $490 billion at the end of October 2008 from $780 billion in October 2007. In steps the U.S. Treasury and the Treasury Supplemental Financing Program (TSFP) to save the day.
(Click on Table to enlarge)The Fed has transferred the job of sterilizing its liquidity injections exclusively to the Treasury since the TSFP account has grown five-fold in just one month (see liabilities Table above). Now when the Fed issues $150 billion in TAF credit, the Treasury sells bonds on the open market (rather than the Fed doing this) and deposits the proceeds into the Fed’s account, currently $559 billion in the U.S. Treasury Supplemental account (the TSFP). The Fed’s stock of treasuries remains unchanged.

So why isn’t this a monetization of Treasury debt? First because the TSFP balance has risen, which is a liability to the Treasury. But more importantly, the Fed has increased its liquidity measures by $1 trillion since August, and reserve balances have ballooned 30 times over, up from $9 billion in August to $261 billion in October. This is not an act of monetization of Treasury debt because banks are hoarding the funds as excess reserves – reserves held in addition to those required by the Fed.

(Click on chart to enlarge)

The ballooning reserves are a result of the new monetary base in the banking system - the Fed’s response to the credit crisis - and not the monetization of new spending by the Treasury.

At some point the Fed may choose to monetize new debt issued by the Treasury (let’s say in order to raise $700 billion to finance TARP), but I doubt it. There is already a new $1 trillion of new liquidity sloshing around in the banking system, posing huge inflationary risks. As soon as the cork that is stopping up the credit flow in the banking system pops, the Fed must remove the excess liquidity in order to avoid an inflationary boom.

Rebecca Wilder

11 comments:

David Pearson November 3, 2008 at 9:52 AM  

Two questions/points on an excellent post:

-Are you saying the reserve balance growth is not monetization, period? Or is it not monetization because the velocity of reserve deposits is zero?

-The Fed's balance sheet is reaching a point where removing liquidity can only happen by disposing of risk assets (unlike in Japan, where the BOJ just sold government bonds). Can a less-levered financial system absorb those risk assets (at par)? I'd imagine the capacity to absorb them is many, many years away. Since this is the case, won't the market begin to predict that the liquidity will turn out to be inflationary under any mild recovery scenario?

-Lastly, can the Fed have any impact on the real economy as long as velocity of reserves is zero or plunging? The idea is that preventing bank failures arrests a contraction in the money supply; but broader M measures are falling due to de-levering. So won't the Fed have to do something to actually "cut checks" to the real economy? The CP facility is a start, but my guess is it only helps large firms with access to guaranteed bank credit back stops. So Fed CP buying is only easing the strain on bank balance sheets, and not contributing to the purchases of goods and services.

If the Fed has to print to purchase goods and services because velocity is plunging, then I believe you will see inflation much sooner than you think.

David Pearson November 3, 2008 at 9:59 AM  

BTW, when I say the Fed may by goods and services, what I really mean is it finances the government's buying (i.e. monetization).

Rebecca Wilder November 3, 2008 at 6:14 PM  

Hi Dave,

Thanks for reading! And thank you for commenting!!

“Are you saying the reserve balance growth is not monetization, period? Or is it not monetization because the velocity of reserve deposits is zero?”

RW: Because the velocity of reserve deposits is close to zero and banks are hoarding cash (albeit inter-bank lending is moving – am writing about that tomorrow). It seems to me that the fed is going back to the old monetary theories – print money until prices (interest rates) are forced to rise.

“The Fed's balance sheet is reaching a point where removing liquidity can only happen by disposing of risk assets (unlike in Japan, where the BOJ just sold government bonds). Can a less-levered financial system absorb those risk assets (at par)? I'd imagine the capacity to absorb them is many, many years away. Since this is the case, won't the market begin to predict that the liquidity will turn out to be inflationary under any mild recovery scenario?”

RW: I agree and this is a very good point…timing. The Fed is absorbing a wide range of collateral in exchange for the funds – not just treasuries. It’s not clear to me how exactly the Fed would unwind its riskier assets unless a market has been defined for them. But I am sure that the Fed is not going to unload its stock of assets until they are good and ready to; thus, there is a larger risk that the Fed unwinds too late, rather than too early. As a broader range of credit indicators turn around, I imagine that markets will start to price in inflation. Gold will rise…maybe, treasuries will sell off, saving will rise, the $US will fall. It’s back to the first half of this year, but for other reasons.

“Lastly, can the Fed have any impact on the real economy as long as velocity of reserves is zero or plunging? The idea is that preventing bank failures arrests a contraction in the money supply; but broader M measures are falling due to de-levering. So won't the Fed have to do something to actually "cut checks" to the real economy? The CP facility is a start, but my guess is it only helps large firms with access to guaranteed bank credit back stops. So Fed CP buying is only easing the strain on bank balance sheets, and not contributing to the purchases of goods and services.”

RW: This is one interesting thing about what the Fed is doing. While interbank lending is functioning just fine, term lending is not. M2 is rising, but in a world of credit, that doesn’t seem to have much stock. De-levering is certainly the worst-case-scenario, and the Fed cannot “force” banks and firms to lend to one another. However, eventually banks will need to earn profit and I think that they will go back to business and mortgage loans. Further, the CP facility is not bounded, so the Fed can print as much money as it wants for that market.

Sovereign wealth funds can/are also potential suitors – I just read in the WSJ that the royal family of Abu Dhabi is putting $11.6 billion into Barclay’s. Stranger things have happened than the Gulf and SE Asia flocking to cheap U.S. deals….

“If the Fed has to print to purchase goods and services because velocity is plunging, then I believe you will see inflation much sooner than you think.”

RW: I agree. Back to classical monetary economics – if you print it, inflation will result. I am much more apt to talk about the risk of an inflation boom going forward, rather than a deflation bust! Further, if Congress doesn’t pay back its new $300 billion stimulus bill, and there are TARP net losses, we may be looking at added inflation by debt monetization (as you suggest).

Awesome, awesome comments! Hope this helps, and thanks again for reading!
R

David Pearson November 3, 2008 at 9:21 PM  

R,

Thank you so much for your responses. They are really helpful.

My sense after reading your comments is that the dividing line between inflation and deflation is thinner than people think. So the less risk of one, the more risk of the other. I think consensus is one is a remote possibility and the other (deflation) is not. This just creates more risk of a shock to long term interest rates, in my mind. Maybe the Fed would be better off being up front with people on this one.

Anonymous November 20, 2008 at 9:58 PM  

Two questions:

1) Are you certain the credit market can ultimately be unfrozen? While I understand that's a common perspective, why would businesses and individuals borrow (or lend) in a severely contracting economic environment? Now, if the monetization spigots open up...sure.

2) Single? ;-)

Rebecca Wilder November 23, 2008 at 6:02 PM  

Hi Anonymous,

Thank you for your comment!

You said, "Are you certain the credit market can ultimately be unfrozen?"

No, not certain. However, with $1.3 trillion of new liquidity in the banking, my bigger concern is inflation. Furthermore, with Obama ready to pass a huge stimulus bill upon Inauguration, the economy may start to improve (grow again) in the second quarter of 2009. As soon as the economy stabilizes and starts to rebound, credit markets are sure to respond.

No, not single. As I state quite clearly in my "about" section, I am happily married to a very handsome German, Matthias.

Thank you for reading,

Rebecca

Stevie b. November 27, 2008 at 1:12 PM  

Rebecca - I have just discovered this THRILLING (yes, I'm not ashamed!) thread. I think I need to read it an awful lot of times 'til I halfway understand it, but meanwhile, in muddled ignorance:

1/ "I am sure that the Fed is not going to unload its stock of assets until they are good and ready to; thus, there is a larger risk that the Fed unwinds too late, rather than too early."
Are you saying this means containing emerging inflation will be near-on impossible because the losses on the Fed's stock of assets as velocity STARTS to pick up (& the time when action needs to be taken) will still be too large to sterilize(?) previous actions in good time?

2/ "As soon as the cork that is stopping up the credit flow in the banking system pops, the Fed must remove the excess liquidity in order to avoid an inflationary boom."
Are you saying in essence that given 1/ above, the Fed will almost certainly not be able to remove(some/a lot/most of?)this excess liquidity?

I look forward hugely to your response - thanks!

Rebecca Wilder November 28, 2008 at 1:16 PM  

Hi Stevie,

Thank you for your comments!

In part 1 (and 2 relates), you asked, “Are you saying this means containing emerging inflation will be near-on impossible because the losses on the Fed's stock of assets as velocity STARTS to pick up (& the time when action needs to be taken) will still be too large to sterilize(?) previous actions in good time?”

Yes, that is exactly what I am saying. Clearly, the risk right now is not adding enough liquidity to the system – hence, the quantitative easing and $1.3 trillion in liquidity added since last year via TAF, PDCF, TSLF, discount window, etc. However, the Fed is accepting collateral (which is doesn’t disclose, by the way) for each of these loans, which could make unwinding the liquidity (taking it back) difficult if the market for some of the collateral (let’s say CMBS????) hasn’t stabilized yet.

At some point, the market is going to price in the risk of inflation: the Fed doesn’t get it right, and is forced to leave the liquidity in the system, resulting in an inflationary boom. However, it is also likely that the Fed has no problem unwinding the collateral back into the market, and the current liquidity infusions did the trick! It’s all going to be about timing, but don’t forget, we have a nasty recession underway, and I expect that this will not be a problem until at least later 2009 or even into 2010.

Thanks again for reading!

Rebecca

Stevie b. November 28, 2008 at 3:58 PM  

Rebecca - thanks mightily for this response. All I would say at this stage is that markets are supposed to discount at least a year ahead, so it shouldn't be too long before we get their verdict...meanwhile it looks to me like a race to the bottom for the dollar, pound and euro - but I guess that's what postponing the inevitable for over a decade leads to.

Mick November 30, 2008 at 12:32 PM  

If, as Nuriel Rubini believes, we are facing another $1-1.8 trillion in credit write-downs, what effect does this have on the potential inflation you are discussing?

RAP STAR May 24, 2009 at 11:25 AM  

THANK YOU

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